Factor Markets AP Economics | June 19, 2014 | Grant Black Center for Entrepreneurship and Economic Education University of Missouri-St. Louis Introduction • Factors of production and factor markets • Factor income • Derived demand for factors of production • Productivity theory and factor markets – Marginal revenue product – Marginal resource cost – Profit maximization Introduction • Productivity theory and factor markets – Effect of imperfect competition in product markets – Effect of imperfect competition in labor markets – Monopsony • Problems with productivity theory in factor markets • Government intervention in factor markets: minimum wage Factors of Production • Any resource used to produce goods and services – Labor – Land and other natural resources – Capital (physical and human) • Factors of production earn income from the ongoing selling of their services • Factor markets = markets where factors of production are traded – Households are suppliers – Firms are demanders Importance of Factor Markets • Determine prices of resources • Allocate productive resources to producers • Help ensure resources are used efficiently Factor Income • Sale of factors of production usually generates largest share of most people’s incomes • Factor distribution of income = how total income in the economy is divided among labor, land, and capital Factor Distribution of Income, 2014 Source: Bureau of Economic Analysis Derived Demand for Factors of Production • Demand for a factor of production is derived from demand for the good/service produced from that resource • Distinguishes factor markets from goods markets Productivity Theory and Factor Markets • Initially assume product market and resource market are both perfectly competitive • Use labor market as example • Marginal revenue product (MRP) = change in total revenue resulting from a change in the quantity of labor – Also called value of marginal product (VMP) Marginal Revenue Product • MRP = ∆TR / ∆QL = (TRnew – TRold) / (QLnew – QLold) • If factor market is competitive, MRP = MPL x P (product price) • MRP curve represents a firm’s demand for labor – Downward sloping due to diminishing returns to labor MRP Example QL TP MPL P TR MRP (output) 1 12 12 $5 $60 $60 2 26 14 $5 $130 $70 3 38 12 $5 $190 $60 4 48 10 $5 $240 $50 5 56 8 $5 $280 $40 6 62 6 $5 $310 $30 MRP Curve $80 $70 Demand Curve for Labor $60 $50 $40 $30 $20 $10 $0 1 2 3 4 5 6 • MRP affected by diminishing returns to labor Marginal Resource Cost • Marginal resource cost (MRC) = change in total cost resulting from a change in the quantity of labor • MRC = ∆TC / ∆QL = (TCnew – TCold) / (QLnew – QLold) • If factor market is competitive, MRC = wage (w) Profit-maximizing Quantity of Labor • Similar to determining profit-maximizing quantity of output – MR = MC • Maximizing rule: MRP = MRC • If factor market is competitive, MRP = w Profit-maximizing Example QL TP MPL P TR MRP (output) 1 12 12 $5 $60 $60 2 26 14 $5 $130 $70 3 38 12 $5 $190 $60 4 48 10 $5 $240 $50 5 56 8 $5 $280 $40 6 62 6 $5 $310 $30 •If wage = $60, profit-maximizing quantity of labor is 3 workers •If wage = $40, profit-maximizing quantity of labor is 5 workers Demand and Supply Model $80 $70 $60 S $50 $40 D $30 $20 $10 $0 2 3 4 5 6 Demand and Supply Model $80 $70 S $60 $50 S’ $40 D $30 $20 $10 $0 2 3 4 5 6 Effect of Imperfectly Competitive Product Markets QL TP MPL P TR MRP (output) 1 12 12 $5.80 $67.20 $67.20 2 26 14 $5.60 $140.40 $73.20 3 38 12 $5.40 $197.60 $57.20 4 48 10 $5.20 $240.00 $42.40 5 56 8 $5.00 $268.80 $28.80 6 62 6 $4.80 $285.20 $16.40 •If wage = $60, profit-maximizing quantity of labor is 2 workers •If wage = $40, profit-maximizing quantity of labor is 4 workers Effect of Imperfectly Competitive Labor Markets • Case of monopsony – Monopsony = single demander of labor – Classic example: one-company town – Other examples: • local fire department (one employer demands workers with certain skills) • Major league baseball (reserve clause limited player mobility) • To hire more workers, business must offer higher wage – MRC curve is upward sloping Profit Maximization in Monopsony • Monopsony still maximizes profits when hiring at MRP = MRC • For monopsony, MRC > w – MRP=w does not apply for monopsony as in perfect competition Monopsony Model MRC w S w*m MRP Q*m QL Monopsony vs. Perfect Competition MRC w S monopsonistic exploitation wpc wm MRP Qm Qpc QL Problems with Productivity Theory in Factor Markets • In real world, substantial differences exist between prices of factors that likely have similar MRP – Wage gaps by gender and race • In real world, some resources are not fully employed and may receive prices higher than their MRP or market-clearing levels Median Weekly Earnings by Gender and Race, 2014 White Women (all African Hispanic Men races/ethnicities) American (men (men and and women) women) $948 $754 $682 $651 *For those aged 25 and over Source: Bureau of Labor Statistics Causes of Wage Differentials and High Wages • Wage differences may result from compensating for “unattractive” jobs, differences in innate talents, and differences in human capital – Productivity theory can account for these issues • Market power – Unionization can push wages above market- clearing levels and above wages in non- unionized sectors Causes of Wage Differentials and High Wages • Efficiency wages – In jobs where workers cannot be supervised easily, wages are above equilibrium to promote higher productivity of workers, which can create wage dispersion and unemployment • Discrimination – Some workers may be discriminated against, which lowers their wages relative to other workers and their employment opportunities Government Intervention: Minimum Wage • Purpose: increase earnings of low-income workers • Predicted simple outcome: increase in wage above equilibrium causes unemployment for some and higher wages for those still employed • Negative effect depends in part on elasticity of demand for labor and structure of labor market – More inelastic, less unemployment – Perfectly competitive vs. monopsonistic Minimum Wage in Perfect Competition w w unemployment Sc Sc Sc” wm w* w* w” Dc Dc Qm Q* QL Q’ Q” QL Covered Sector Uncovered Sector Minimum Wage in Monopsony MRC w S wmin w*m MRP Q*m Qmin QL Wrap Up Questions? Grant Black Center for Entrepreneurship and Economic Education University of Missouri-St. Louis [email protected] 314-516-5248 .